The incompetence dodge

I was talking the other day with some very smart Hill types who were saying that the big issue in financial regulation is the need to attract a better class of regulator. The Federal Reserve needs more money, more prestige and more autonomy. Regulators should feel like FBI agents, not like hall monitors. That sort of thing.

I'm agreeable to all that, but I also think it's a bit misguided. Back in October of 2005, Sam Rosenfeld and Matt Yglesias, my then-colleagues at the American Prospect, published a brilliant essay calling out liberal hawks who were hiding behind "the incompetence dodge." The dodge, they said, was the tendency to distract from the war's fundamental flaws by focusing on its poor execution. In a post I can't locate now, Matt argued that if the only way to get somewhere was to walk across a tightrope while juggling knives, you ought to think really about whether you need to get there. Because, let's be honest, you're not that good a tightrope walker/knife juggler.

The FinReg discussion is suffering from something of a similar fallacy: There were so many egregious mistakes made by so many different players that it's easy to focus on the specific mistakes rather than on the forces that led every single actor -- from regulators to ratings agencies to risk departments to traders -- to fail so terribly. But just as you don't want to have to launch a war with Iraq because it probably won't go well, you don't want to have to rely too heavily on regulators effectively policing an improbably massive, hyper-profitable Wall Street in boom times, as that probably won't go well, either. Your system has to be fairly robust against incompetence, because competence is not an independent variable. When Wall Street loses its mind, so, too, do the people who are close to it.

I don't understand what you are suggesting here, Ezra. We shouldn't rely on regulators to... um... regulate Wall Street? What is the alternative? What kinds of things should Congress do to make the system "robust against incompetence"? The Iraq war analogy falls apart almost immediately, since we can't just choose not to have a financial system.

I think this gets at the heart of the problems of government, on virtually every issue. Markets, economies, and humanity are simply too complex, varied, and intricate to allow a small set of officials to be able to regulate them efficiently. Now, it doesn't necessarily follow that we shouldn't try at all, just that the current approach is flawed at best. Financial regulators sit astride a Jupiter-sized financial system that they couldn't possibly understand.

The fatal conceit is that supporters of this bill, and a larger, more powerful government generally, believe that they can tame the beast if they set things up just so.

Arnold Kling has written eloquently about what could be called "incentive-based" solutions to the problem of regulation, e.g. altering the resolution process so that derivatives are one of the last things to get paid off. This doesn't forcibly impose costly requirements on anyone, it simply aligns the incentives so that many fewer people will partake of the derivatives trade in the first place.

Thank you for this. I've been trying to follow the FinReg saga as much as possible, but whenever I find myself deep in the weeds of figuring out derivatives and shadow banking, my instinct is to back out and survey the big picture. I start thinking to myself: But have we identified and stabilized our critical systems? And in monitoring the details of all this stuff (as much as I understand), it's hard for me to see that we have. Your post on FinReg's killer app: http://voices.washingtonpost.com/ezra-klein/2010/03/finregs_killer_app.html made a lot of sense in that respect.

My understanding of this issue is simplistic, yes, but I really appreciated the point you made when you later talked about potentially insufficient capital requirements in the Dodd bill:

"Dodd's argument is that Congress should not micromanage the financial sector. But the problem isn't an abundance of micromanagement, but an absence of macromanagement."

I totally buy that. And in a weird way, all these detailed technical discussions of the minutiae kind of undermine my impression that serious macromanagement is ever going to happen. Maybe my impression is wrong. But there it is.

There are, broadly speaking, two stages of regulatory action: The first is the policy setting stage, the second is the enforcement stage. The argument seems to be that we need to make sure that Congress sets clear bright line rules to prevent any discretionary agency action. This ensures that whatever decision Congress makes now—whether it is too strict or too lax—to stay in force ad inifinitum.

This works, of course, only so long as Congress is infallible. If a regulator can step in to fix policy, to allow industry to innovate in a socially beneficial way or prevent them from acting in a socially harmful way, then regulatory action can be good. Otherwise, market abuses will continue (without the ability for regulators to stop them, as the SEC is doing with CRAs right now) or market innovation may be stifled (though this hasn't happened in recent years). This is especially important when, as with financial sectors, market participants have better information than Congress and will rapidly develop workarounds to hardline rules.

"There were so many egregious mistakes made by so many different players that it's easy to focus on the specific mistakes rather than on the forces that led every single actor -- from regulators to ratings agencies to risk departments to traders -- to fail so terribly."

You make it sound likes there's a single cause/mistake that's analogous to "don't go to war with Iraq" that people are ignoring or dodging by getting caught up in the little things. If that's what you think, I'd love to hear what it is and possibly solutions that'll keep us from repeating it. I'd love to know the cure for greed. :)

I don't really think there is, ftr. I think it's as you say... many people made many mistakes all at once, and that there were a number of converging forces that laid the groundwork for what we just experienced. Therefore, it's not only appropriate but inevitable that we'll have to focus on some large, but also some discrete changes to our system. Government jobs are crap for pay and prestige, and regulatory capture is a real problem. I think improving these positions sounds like a great idea.

Well, geez, can't we once again require the separation of commercial and investment banking, so as to insulate the commercial bank customers from the gambling of the investment bankers and hedge funders working on commission and who may amass great wealth before the latest bubble bursts?

If the investment banks and hedge funds bet badly and go down the tubes, vaja con dios o diablo. Those who choose to trade with the investment banks in exotic derivatives will just have to take their losses. And we, the taxpayers, through our government need not bail them out to preserve the integrity of the commercial banking sector.

Can't we at least require that rating agencies are not working for those whose securities they rate?

I suspect that much of the bad behavior of bankers will be cured over the short term by the ensuing, protracted civil litigation; but, in the long term, their will always be the slimy dogs who put personal enrichment ahead of the common good.

So let's at least protect the savings and of we unsophisticated investors not trading in obscure, exotic investments.

But it's also crucial to note that when Republicans are in office they don't want regulators to be effective and competent. They don't want regulation in the first place; it conflicts with their simple-minded ideology, so they chose people purposely who will do their jobs as regulators as little as they can get away with.

Is there really anyone still stupid enough to be buying synthetic collateralized debt obligations? Fab had it right with his "intellectual mastur...... that no one can price" line. I think the market for these products has dried up as pricing even the counterparty risk, never mind the systemic risk, is next to impossible.

Is there really anyone stupid enough to be giving out home loans with 3.5% down? Who would securitize that loan? Oh...wait...it's the taxpayer. We're the only suckers left.

Ezra, you're undervaluing the contribution of smart, well paid, confident regulators in shaping the discussion. If the SEC were run by such people, well organised, and committed to what they do, they might have more of a chance of proposing, and getting passed, regulations that allow them to regulate effectively.